When you buy an annuity you know the odds are against you. If you outlive the average life expectanc...
When you buy an annuity you know the odds are against you. If you outlive the average life expectancy for your age group you will have made a good investment, but die early and you will have lost your capital in exchange for a few years worth of income. The only consolation is that you will not be around to ponder the alternative and possibly much better investment options that were available to you.
One such alternative is to invest in income shares of split capital investment trusts.
Split trusts issue two or more classes of share, each with differing entitlements to income and capital, and hence designed to satisfy different investment objectives. Most split trusts have at least one class of income shares within their structure.
Income shares come in many guises. Some have lower levels of dividend yield - perhaps 5% to 6% - and carry good prospects for capital appreciation. Others may offer exceptionally high yields - perhaps in excess of 20% - but a capital value certain to decline over time.
Income shares can be an attractive alternative to the purchase of an annuity. An income share, like an annuity, will provide a relatively high level of income. Unlike an annuity, the capital invested is not necessarily sacrificed to secure the high income. The income share will however have a fixed term and so does not guarantee an income for life.
The longest dated split trust is M&G High Income which runs to March 2017. The income shares of this trust provide a net dividend yield of 7.3% with the prospect of dividend growth over the life of the trust. Since the trust's launch in 1997 dividends have increased by approximately 2.5% a year. The current share price stands at 61p and the shares are due to be repaid in March 2017 at 70p.
For the repayment price to be met, the trust's portfolio will have to appreciate by around 3.8 % a year. This is not too demanding a requirement to gain the chance of retaining, and indeed enhancing, the capital sum that was initially invested in addition to the prospect of a high and rising income stream.
Compare the 7.3% net return from M&G High Income and the prospect of a return of capital with the annuity rates currently available. The Annuity Bureau surveyed annuity rates on 19 April 2000 and found the best rate for a 65-year-old non-smoking male (on a £100,000 investment) was 8.428%. The fifth and tenth ranked suppliers paid 7.723% and 7.491% respectively (Investment Week, 24/04/00).
Income shares can also offer greater flexibility than annuities. They do not have to be held for the full term. They can be sold on the stock market should the investor's needs change and a lump sum of capital becomes preferable to a regular income. If the investor dies the income shares will have a market value that can be realised to the benefit of their estate.
With a traditional annuity there would be no residual capital value to benefit the deceased's estate. In this respect income shares have considerable appeal over annuities for investors who want to try to retain their wealth to pass on to their relatives.
Annuity income shares
Some income shares do involve a total loss of capital if held to their wind-up date. Such shares are known as annuity income shares. These shares will tend to offer the highest yields and be repaid on a specified future date at a nominal amount - perhaps as little as 0.1p per share.
The annuity income shareholder is not directly exposed to the capital performance of the trust's portfolio of investments. Whether the portfolio rises or falls in value will have negligible effect given that the income shares are repaid at only a nominal amount. The capital performance of the fund is of concern to the annuity income shareholder only in as far as good performance may enable the trust to grow the dividend at a faster rate.
An equity dividend can never be regarded as absolutely secure but historically the market dividend (the average for all companies) has traced a fairly steady upward path only occasionally faltering. So generally the buyer of an annuity income share can reasonably expect a maintained or growing dividend.
The income shares which hold the prospect of the best returns are geared ordinary shares, also known as income and residual capital shares. This type of income share generally carries the highest risk. The yield is likely to be lower than an annuity income share of similar duration but the shares hold the prospect of capital appreciation. Their capital performance is geared to the overall performance of a trust such that at lower levels of growth in underlying assets the income share may end up with no residual capital value, but at higher levels of growth significant capital gains can be achieved.
Most geared ordinary shares have a fixed term. An example of this type of income share is BFS Small Companies Dividend Trust. The shares currently trade at 74p on a net yield of 10.8%. There is no growth in the trust's portfolio and the income shares would redeem at around 30p. A 4% growth rate would be needed to repay the shares at their current share price while higher rates of growth would provide capital appreciation in addition to the high and potentially growing income.
Income shares can certainly be considered as an alternative to an annuity where life expectancy is under 10 years because there are almost 40 different income shares with maturity dates of between five and 10 years to choose from.
With only two split trusts currently offering income shares with a maturity of more than 10 years, investors requiring an income stream for longer periods will have to focus on shares with a greater prospect of retaining their capital value so that reinvestment into other suitable income shares can be made when the initial investment reaches the end of its term.
A better option is perhaps to invest in a fund or managed portfolio of income shares
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